Friday, 4 July 2014

Taylor rules: the ZLB and Euro Diversity

John Taylor originally suggested his rule as both a good guide to
what central banks actually do and also one that “captures the spirit of the
recent research”. It has been used ever since as a yardstick by which to
measure monetary policy. However there are well understood reasons why it is
likely to be a poor yardstick in a severe recession.

First some theory. In a world of certainty, when inflation
expectations are equal to the inflation target, the optimal interest rate to
set is one that delivers what is called the ‘natural’ real interest rate. You
can describe this as the real interest rate that would achieve a level of
demand and output which eliminated the output gap, and put unemployment at its
natural rate. At that point, there should be no pressure from the domestic
economy for inflation to rise or fall.

In this context it becomes obvious why the output gap (or
deviation of unemployment from the natural rate) appears in the Taylor rule.
Yet in reality our estimates of the output gap are poor, so it also makes sense
to include the difference between inflation and its target in the rule. Finally
the rule also contains a constant, which is an estimate of what the natural
interest rate would be if inflation was at target and there was a zero output
gap. As to the coefficients on inflation and output, you want those to be
modest to avoid overreacting to false signals and to allow for lags between
interest rate changes and their impact on inflation.

The best way to think about the Taylor rule is as a simple
‘horse for all courses’. It is designed to be a robust rule for all situations:
booms as well as busts, small as well as large deviations from target, and
where we have no additional reliable information.

In the current recession we know a number of additional things.
First, the natural real rate of interest is likely to be a lot lower than the
constant in any Taylor rule. There are a number of reasons for this. In the
short term a balance sheet recession means that consumers want to save much more than they would normally, so the
natural rate has to be unusually low to offset the impact of this on demand. In
the longer term we have the issue of secular stagnation, which is one reason
why policymakers in both the UK and US say that even when the economy recovers
interest rates are likely to be lower than they have been in the past.
(Austerity is another.)

There are other factors as well. At low levels of inflation,
inflation appears to be less responsive to excess
demand. On its own this means that the coefficients on excess inflation in a
horse for all courses Taylor rule will be too low when inflation is below 2%.
(The possibility of hitting the Zero Lower Bound can also imply the same
thing.) If forecasts indicate that inflation will remain below target for some
time, that can also suggest we can afford to react to inflation
being too low by more than the Taylor rule would suggest.

If you want a practical illustration of all this, consider this
post from Zsolt Darvas at Breugel. It uses a
typical Taylor rule for the Euro area, and finds that interest rates set by the
ECB have been below the level implied by that rule every year since about 2001!
That is a clear illustration of the problem of assuming a constant long run
natural real interest rate, in this case beginning with Bernanke’s savings
glut. Exactly the same points arise in trying to assess whether US monetary
policy was too expansionary in the mid-00s. This same rule also implies that
the ECB raised rates by too little in 2010/11, which is clearly silly in the
light of what subsequently happened. (Again we had more information, in this
case about austerity.)

However the Breugel post is not really about how appropriate
the ECB’s monetary policy is for the Eurozone as a whole. Instead it focuses on
what the rule tells us monetary policy might have been in each individual
Eurozone economy, if they had retained their own currency and had floated. Or
to put it another way, it tells you for which countries the ECB’s policy is too
tight, and for which it is too easy. Used in this way, the analysis is a handy
way of combining information on inflation and unemployment diversity across the
Eurozone.

Where is the ECB’s policy too tight? There are the obvious
countries: Spain, Portugal, Italy and especially Greece. But there is another,
which is the Netherlands. There is no mystery here: CPI inflation is currently (May) 0.8%, the harmonised rate is
0.1%, and unemployment has been over 7% this year, compared to an average of
below 4% from 2000 to 2007. As the Netherlands does not have an independent monetary
policy, it desperately needs a countercyclical fiscal policy, yet instead it is
locked into the austerity trap imposed by the Eurozone’s fiscal rules. All of
this was horribly predictable, which is why I wrote these posts: May12, Sept12, June13, Dec13.

These fiscal rules are not going to be abolished anytime soon,
even though their intellectual rationale has disappeared. The best that we can
hope for is that their impact can be softened or partially circumvented by
allowing additional public investment spending: see Reza Moghadam from the IMF here, or Wolfgang Münchau here and here, Guntram Wolff here, or Mariana Mazzucato here. But if in the future anyone wants to see
the clearest example of where these rules led to large and completely
unnecessary social costs, just look at the Netherlands.

6 comments:

An additional factor in the Netherlands: the Dutch pension system, executed by De Nederlandsche Bank, de facto requires pension funds to raise fees (part of wage income) during recessions, which is of course totally pro-cyclical.

There’s nothing very natural about the “natural rate of interest”. In contrast to Simon’s definition, my jaundiced definition of the natural rate of interest is: “the rate of interest that closes the output gap on the very questionable assumption that in a recession, demand should be raised PURELY by boosting lending based forms of economic activity (i.e. primarily investment)”.

By the same token I would question the assumption (which is possibly made in some parallel universe) that demand should be adjusted purely by adjusting car, baked beans and lollipop sales.

In a free market (i.e. a market where wages are not sticky downwards) a recession causes wages and prices to fall, which raises the real value of the monetary base and national debt (the Pigou effect). That induces holders of the latter assets to spend more on a WIDE VARIETY of stuff: not just investment goods. Doesn’t that make more sense and thus shouldn’t we imitate that “sensible” solution to the problem by upping a WIDE VARIETY of different forms of spending, public and private, in a recession?

Yep. Apologies for plugging my own research: 10 years ago David Tulk and I did a grid search over simple rules (like the Taylor Rule, but trying different parameter values, and throwing in the exchange rate too). We could not find one that outperformed the actual policy of the Bank of Canada. The Bank knows that the natural rate will vary over time, and uses more information than is available in the simple rule. http://www.bankofcanada.ca/2003/10/working-paper-2003-31/

Good point Nick: Good well thought out policy beats a simple rule every time but the financial talking heads need simplicity. I can remember BOC research that stated unequivocally that the natural rate was 8%. Nicely, the Bank has learned from its mistakes.One challenge is that the unemployment rate does not really measure the pricing power of labour or of employers in any broad sense. It also does not measure pricing power in the market place (hence the retail results we are seeing).

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